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IRS addresses key insurance issues under the corporate alternative minimum tax
February 2023
In brief
The Inflation Reduction Act, enacted August 16, 2022, imposes a corporate alternative minimum tax (CAMT) on “adjusted financial statement income” (AFSI) of "applicable corporations." The CAMT is effective for tax years beginning after December 31, 2022.
The IRS and Treasury recently released Notice 2023-20 (Notice), providing interim guidance intended to “help avoid substantial unintended adverse consequences to the insurance industry” under the new CAMT. The guidance addresses time-sensitive issues concerning the treatment of life insurance company separate account assets that are marked to market for financial statement purposes; the treatment of embedded derivatives arising from funds withheld and modified coinsurance contracts; and tax issues that arise with respect to certain formerly tax-exempt entities for which Congress provided special transition rules to determine tax basis in assets held when the repeal of their exemption became effective.
Notice 2023-7, which provided a first round of interim CAMT guidance, promised that the issues outlined therein would be addressed before the issuance of forthcoming proposed regulations. The subsequent Notice provides that taxpayers may rely on the new interim guidance until the proposed regulations are issued.
Action item: Insurance companies should confirm that the guidance in the Notice operates as intended with respect to their own contracts and reinsurance agreements, particularly because the Notice introduces a number of new defined terms. In addition, insurance companies will need to consider whether to comment on the guidance provided in the Notice. Comments are due April 3, 2023. Noninsurers may view the Notice as a reminder that the IRS and Treasury have promised more interim guidance before they issue proposed regulations.
In detail
In general
The CAMT imposes a 15% minimum tax on AFSI of applicable corporations. In general, a taxpayer's AFSI is defined as the net income or loss on a taxpayer's applicable financial statement (AFS) for a tax year, adjusted to take into account only income or loss allocable to the applicable corporation as well as for certain book-tax differences such as tax depreciation and tax credits. Consistent with Section 451(b)(3) and the related regulations, an AFS is a financial statement prepared in accordance with GAAP or IFRS, reported to the SEC, or otherwise used for reporting to shareholders or credit purposes, or as otherwise specified by Treasury in regulations or other guidance.
An applicable corporation subject to the CAMT for a tax year is a corporation (other than an S corporation, regulated investment company, or real estate investment trust) that meets an AFSI test in one or more tax years before the current tax year and ending after December 31, 2021. Under the "general AFSI test," a corporation will be an applicable corporation if its average AFSI (when aggregated with that of other members of the corporation's single-employer group) over the three tax years ending with the relevant tax year exceeds $1 billion.
A corporation that is a member of a foreign-parented multinational group (FPMG) must apply a two-part AFSI test (the FPMG AFSI test): (1) the average annual AFSI of the domestic corporation(s) must be at least $100 million (when aggregated with that of other members of the corporation's single-employer group), and (2) the average annual AFSI of all members of the FPMG over the three tax years ending with the relevant tax year must exceed $1 billion. In determining the AFSI of all members of the FPMG for purposes of the $1 billion test, AFSI is determined without the adjustments relating to a partner's distributive share of partnership AFSI, certain items of foreign income, effectively connected income, and defined benefit pension plans.
Observation: The CAMT affects a significant number of insurance companies, and comment letters already submitted to the IRS and Treasury have raised a number of insurance-specific issues. The three issues addressed in the Notice – accounting for variable contracts and similar contracts, embedded derivatives arising from reinsurance, and “fresh start” asset basis of formerly exempt companies – were considered to present the most urgent need for guidance.
Accounting for variable contracts and similar contracts
In the case of variable life insurance and annuity contracts, changes in value of the insurer's investments result in changes in obligations to policyholders. For computing both AFSI and taxable income, these amounts generally offset and there is no economic income to the insurer. Applying Section 56A(c)(2)(C) (concerning equity investments) and (D) (concerning partnership investments) literally could prevent mark-to-market accounting for the investments, even though the offsetting reserves still would take changes in value into account. The result of this mismatch could create a significant tax liability in a particular year that exceeds a company's AFSI, regular taxable income, or economic income from a transaction.
Section 3 of the Notice addresses this issue for both domestic and foreign companies. Under section 3, changes in the amount of Covered Obligations — generally, life insurance reserves — are disregarded to the extent of amounts excluded from AFSI under one of two specific adjustments. That is, section 3 defines the Section 56A(c)(2) exclusion amount as amounts that are (1) taken into account in net income of a Covered Insurance Company and (2) disregarded under either rules that apply to investments in corporate stock or rules that apply to partnerships. Thus, the guidance seeks to correct a mismatch between asset gains and losses, and changes in offsetting reserves, by excluding from the reserves an amount equal to what was excluded from gains on assets. In addition to domestic variable contracts, which are defined in the Section 817(d), the provision of the Notice also applies to insurance company closed blocks and to "similar contracts" that are issued by foreign insurers (together defined as Covered Variable Contracts).
Section 3 also includes an example illustrating how the rule applies to an insurer that issued a variable life insurance policy. After walking through the provision and its mathematics, the example observes that "both the unrealized gain and offsetting change in the Covered Obligations are disregarded for purposes of determining A's AFSI, which eliminates what would otherwise be a difference between A's AFSI and A’s life insurance company taxable income.”
Observation: The Notice utilizes a number of defined terms — Covered Insurance Company, Covered Variable Contract, Covered Investment Pool, and Covered Obligations — that appear nowhere else and have no significance apart from the CAMT. Insurers should pay attention to these new definitions in analyzing whether the guidance applies to them.
Observation: Section 3 of the Notice addresses only financial accounting gains and losses that are disregarded under Section 56A(c)(2)(C) or (D)(i). The Notice observes that Covered Variable Contracts generally are similarly treated for GAAP and IFRS accounting, and welcomes comments in this regard. Amounts that are disregarded for tax purposes under other provisions may be addressed in future guidance, such as guidance on other comprehensive income (OCI).
Observation: Because section 3 of the Notice is narrowly tailored to insurance-specific accounting, it is difficult to predict how the IRS and Treasury might approach other CAMT issues that involve unrealized gains or losses.
Embedded derivatives arising from reinsurance
In conventional coinsurance, an insurer transfers both assets and risks (reserves) to a reinsurer, representing a share of the business that is reinsured. Funds withheld coinsurance and modified coinsurance are different because, in each case, the insurer retains both legal title and financial accounting ownership of assets that support the reinsured business, and records a liability to the reinsurer reflecting changes in the value of those assets. Whereas the insurer records changes in the value of assets in OCI, it records changes in the related liability to the reinsurer in net income. Likewise, the reinsurer reports changes in the liability in net income, even though in conventional coinsurance the reinsurer would account for changes in value in its own OCI.
The difference between conventional coinsurance and funds withheld or modified coinsurance is sometimes referred to as an "embedded derivative" even though it is not a derivative as that term ordinarily is used in other contexts.
Section 4 of the Notice addresses the CAMT treatment of both funds withheld reinsurance and modified coinsurance contracts (defined as Covered Reinsurance Agreements). For the ceding company in a Covered Reinsurance Agreement, changes in net income that result from a change in the amount of Withheld Assets Payable corresponding to unrealized gain or loss on Withheld Assets are excluded from AFSI. For the assuming company, changes in the amount of Withheld Assets Receivable likewise are excluded from AFSI, except to the extent risks are retroceded to another company. The exclusion provided under this general rule does not apply to the extent the Covered Insurance Company elects to account for one or more items under the reinsurance agreement at fair value on its AFS.
Section 4 includes an example to illustrate how the rule applies in the case of Funds Withheld Reinsurance. Under the example, the ceding company excludes from AFSI a change in Withheld Assets Payable that corresponds to an unrealized gain not included in AFSI. Thus, the example demonstrates the correction of a distortion from the perspective of the ceding company. The reinsurer correspondingly excludes the unrealized gain from the determination of its own AFSI.
Observation: Settlements under a typical modified coinsurance agreement typically are made on a net basis. For modified coinsurance, there typically is not a separate notion of Withheld Assets Payable and Receivable. It is not yet certain whether technical issues may arise as a result of the definitions in the Notice.
Tax basis of “fresh start” entity assets
From time to time over the past several decades, Congress has repealed the tax exemption of a number of organizations by statute. The Notice identifies a number of these situations affecting several dozen specific taxpayers (Fresh Start Entities), most of which are insurance companies.
In each identified case, Congress also has provided a "fresh start" basis for purposes of determining gain or loss on the sale of assets, and for purposes of depreciation and amortization. The “fresh start” basis of an asset generally was equal to an asset's fair market value as of the date the organization became taxable. The effect of a fair market value "fresh start" basis was to ensure that income or loss attributable to appreciation or depreciation during exempt periods is not subject to tax in future taxable periods. Absent relief, the CAMT could apply to an entity solely because "fresh start' basis applies only for regular tax purposes and not for purposes of AFS net income.
Section 5 of the Notice addresses this issue by providing that, for each Fresh Start Entity, AFSI is determined using the adjusted basis rule that was provided in the original legislation that made the entity taxable and established the entity's special tax basis. Thus, the Notice preserves for CAMT purposes the basis provisions that were intended to apply to each entity, and does so in a manner that is at least analogous to the CAMT approach for tax depreciation.
Forthcoming regulations and requests for comment
For each of the three issues addressed in the Notice, the IRS and Treasury explain that it is anticipated that forthcoming proposed regulations will be consistent with the interim guidance in the Notice, and that taxpayers may rely on the Notice in the meantime for tax years beginning after December 31, 2022. In addition, the Notice requests comments on a number of issues to assist with drafting those regulations, including comments on situations where the interim guidance should be extended to other transactions or entities. The comment deadline is April 3, 2023.
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